Price Your Rental Property Based On The Risks You Are Taking

Ingo Winzer
, ContributorI write about investing in local real estate markets.Opinions expressed by Forbes Contributors are their own.

To figure out the price you're willing to pay for a rental property, you estimate the rent you might get, the annual costs you'll have to pay, and what it might take to first fix the place up.

When you've calculated the net annual revenue, you divide by a capitalization rate to come up with the maximum price you're willing to pay after deducting the fix-up costs. The cap rate basically is the annual return you expect. (Of course, you hope to pay a lower price and get a higher return.) These days that rate may be around 4 percent, so if you expect a net return of $20,000 per year, you should be willing to pay up to $500,000 for the property.

But if the cap rate is 5 percent, you should only pay $400,000. Clearly, the cap rate makes a big difference. How do you know which cap rate to use?

Traditionally, you find out from a broker what the actual cap rate has been on recent transactions in your area. Finding recent cap rates is an informal process, there aren't published figures because most buyers don't want to tell you.

But here's the point - even if you HAD that information, how confident are you that other buyers knew what they were doing? Just because other people used a cap rate, does that mean you should, too? Every time you're assured that professional investors know what they're doing, remember that there was a giant real estate crash in 2008.

(AP Photo/David Zalubowski)

We developed a calculation for cap rates for local markets at my company Local Market Monitor by starting at the other end. Forget what rate other investors are using - what rate should YOU be using? A rate that reflects the risks you're taking.

We start with a market rate for roughly comparable investments and add premiums for risks that can be anticipated. We use the Bank of America Merrill Lynch effective yield on BBB corporate bonds - widely available - as a market rate and add a premium for investing in real estate, a premium for the chance that local rents will fall, and a premium for the chance that local home prices will fall.